About five or six years ago, a neighbour asked me for some help with his mutual fund investments. I went over his portfolio and saw that one midcap fund looked a bit dubious. Instead of just handing him the name of an alternative, I encouraged him to use Value Research Online and find one himself.
A few days later, he told me that he had decided that the best alternative to that midcap fund was a liquid fund. When I asked him how he had come to this conclusion, he told me that the liquid fund was rated five-star by Value Research and the NAVs of the two were almost identical: one was ₹37 and the other ₹35.
To all of us who understand mutual funds, this is an absurd idea, but it seemed like a natural thing to him. Note that I am not mocking him. He is a successful businessman who started from scratch and found considerable success in just 15-20 years. He understands money well, in the way that an entrepreneur does.
And that is exactly what made the episode stick in my mind. If someone like him could arrive at this, then the mistake is not a matter of intelligence. It is a matter of vocabulary.
The price problem
In fact, the blame lies with the way all of us who are familiar with funds talk about NAV. We refer to it as the 'price' of a fund which you pay to 'buy' fund units.
Now, if you wanted to buy a car priced at ₹5 lakh and you were told to find an alternative, you would start looking for other cars which cost around ₹5 lakh. If NAVs are loosely referred to as the price of a fund, then people will bring their existing mental model of what the word means to mutual funds as well. You can't blame them.
The problem is even greater in the case of new fund offers (NFOs), which are almost always priced at ₹10. There is no accounting or regulatory reason for this. A fund could just as well start at ₹100 or ₹1,000.
When a fund is launched at ₹10 and established funds in that category are at ₹80 or ₹300 or whatever, then the car-showroom mental model gets applied in the minds of many investors.
The new fund looks cheap. The old fund looks expensive. Neither is true.
The simple maths
It's easy to demolish this in a few seconds.
Let's say there are two funds with identical portfolios, one with an NAV of ₹10 and the other ₹500. You invest ₹5,000 in both, which means you have 500 units of the first and 10 units of the second.
Now the market rises and both portfolios gain 10%. Your ₹5,000 becomes ₹5,500 in both.
The only thing that matters is the portfolio, meaning the fund manager's skill and competence. The NAV is irrelevant.
The NFO illusion
Five years ago I said that the fault lay with the way the industry, its salesmen and we experts talk about NAV, rather than with investors.
Today I would pass a harsher judgement.
This ₹10 NFO problem is a misunderstanding that is extremely useful to mutual funds and their sales people. They know what the ten-rupee 'price' does to the thinking process of the new investor, and so it won't change.
Look at when NFOs get launched. They cluster after markets have run up, when new investors are walking in. That is not a coincidence.
A ten-rupee unit sold to someone who has never owned a fund before is the easiest sale in this business.
There are some honest exceptions.
A few years back, when Indian investors were first presented with the opportunity to invest abroad, all the options were new funds. They were investing in a market which had proven credentials. They were investing through a fund of funds, and the underlying funds had a history.
There could still be cases like that. But the test is the same: is there something in the portfolio that you cannot get from an existing fund? If the answer is no, then ₹10 is the only thing being sold.
The red flag
The basic idea is wrong. Low or high NAV is irrelevant as a characteristic on which to base the decision to invest in a fund.
In fact, this idea is so thoroughly wrong that it can serve as a good indicator for detecting a fund salesperson or 'advisor' who deliberately misguides you.
So remember this: anyone asking you to choose a fund because it has a low NAV is misguiding you, and you should stop dealing with that person or outfit.
There are no exceptions to this rule.
Dhirendra Kumar is founder and chief executive officer of Value Research, an independent investment advisory firm